What is duration in finance? Understand the concept now!
Understand what duration is in finance and how it is calculated!
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What is duration in finance?
We often come across financial market terms that raise a number of questions.
However, learning what these terms mean is essential for you to increase your knowledge about the financial market and, therefore, better evaluate investments and their main characteristics.
And that's why in today's article, we're going to show you what duration is in finance and how it's calculated.
Want to know more about the subject? Keep reading.
What is duration in finance?
Duration means duration.
In the world of investments, it is the average time in which you will receive payment for your investments, that is, the amount invested and the fees.
This means that the longer the duration, the longer it will take for the investor to receive back the invested amount. Therefore, the shorter the duration, the faster the investor will receive the invested money.
In short, duration corresponds to the average period in which the person who invested in a security fixed income, it will take to recover the invested capital plus interest rates.
When an investor invests in a fixed-rate or hybrid security (yield composed of a variable part and a fixed part), payments may be made before the maturity date.
These payments are called coupons and are made up of the profitability relating to the stipulated term.
What is duration for?
By performing the calculation, the investor can know the average time it will take to receive the amount invested and the interest.
This calculation is very important. After all, there is a difference between pre-fixed interest rates, which are defined as soon as the investor acquires the security, and post-fixed interest rates, which follow a financial indicator and can vary over time.
As you can see, there are variations in the interest rates, which causes variations in the present value of the security.
How does duration work?
In the financial market, this concept has a very specific meaning.
However, to help you better analyze this concept, you can think about a business's cash flow.
Imagine a company that sells on credit to its consumers, resulting in accounts receivable over the months.
In this case, duration is the average period that the company needs to wait to receive the amounts owed by its customers.
Therefore, it is essential that the company in question knows exactly what its main financial needs and obligations are, until it receives the amounts owed.
In fixed income investments, duration measures the time required to receive income coupons (interest payments paid periodically).
However, the term of a security does not necessarily correspond to a period of six months. In other words, the duration depends on the updating of the prices of the fixed income security and the division of payments during the period.
It is important to remember that in post-fixed securities (which have profitability linked to a financial indicator), this does not have as much of an impact.
How is duration applied?
Duration is applied to fixed-rate securities that pay periodic coupons.
In fixed-rate securities with semi-annual interest, the investor already knows the interest rates at the time of investment. However, he receives the income proportional to the amount invested every six months.
Therefore, analyzing duration makes more sense for securities that return the investment with interest in installments, during the investment period.
The investor does not receive remuneration total at once. Therefore, the duration is shorter than the maturity of this investment.
For a fixed income portfolio (a set of assets), duration is a weighted average of the time needed for the investor to wait to redeem, at present value, the principal plus interest.
How to calculate the duration of an investment?
Now that you know how duration works, you need to understand how the calculation is done.
When calculating the duration, you will have an average of how many years, on a weighted average, you will wait to receive the amount invested plus interest.
Duration is defined according to three factors: value of the pre-fixed interest rate, frequency of payment of the bonds and term of the investment.
The formula for calculation is as follows:
Where:
• D – Duration
• T – Term of each cash flow of the security
• C – Cash flow from the title
• R – Pre-fixed rate
Why is it important to understand the meaning of duration?
Although this term is very important, it is not well known among investors (even among those who prefer fixed income).
However, understanding this concept is very important.
After all, having this knowledge can help you optimize the risk-return relationship of an application.
Building a fixed income portfolio with only short-term securities can harm profitability.
However, when creating a portfolio of only securities with a high average term of collection, the risk also becomes greater.
And that’s why understanding this concept is important when creating a diversification strategy.
What is the relationship between duration and the risk and price of bonds?
When the security has a long maturity, the fluctuation related to the interest rate will be greater.
Therefore, duration also represents the risk of variation in the current price of the security when compared with the variation in interest rates.
Therefore, the financial market sees duration as an indicator of risk.
And that is precisely what this risk refers to: the uncertainty that the market has about the variation in interest rates.
After all, the longer the term, the longer the duration. That is, when there are no coupon payments.
Furthermore, the longer the duration, the greater the risk of this investment.
What is the duration of a bond?
As already explained, duration means duration, so do you know what a title is or how long it lasts?
Changes in interest rates can affect the value of your fixed income positions. With the duration, you can observe and evaluate how and even when the value of a security can be affected by rising interest rates.
With this function you can measure the interest rate risk of a fixed income security. It considers different factors, for example: term, profits and possibility of early redemption.
The factors, in turn, are counted in a single sum that measures the perception of the value of a security in relation to variations in interest rates.
In short, the duration of a security is the regular time of its payment movements weighted by its values.
The duration of a security is used to show how long it will take for the product to return. In investments, time is essential to assess the risks of an investment.
Therefore, it is very important to know what is duration in finance and how to analyze this time and changes in interest rates.
This way, you can know how and when to act and, therefore, bring more security to your investments.
How to interpret duration?
At this point in the game, if you are an average investor, you have already figured it out. o which is duration and how important it is in your applications.
However, in addition to knowing what it is and its importance, you already know How to interpret duration when choosing your investments?
First of all, you need to observe the term, that is, the longer the term, the longer the duration. If there is no payment of coupons.
However, the duration also influences the risk, this means that the bigger the duration, the greater the investment risks.
Of course, the opposite is also true: investments with a shorter duration offer less risk.
Coupon-paying bonds should also be considered when interpreting duration.
Bonds that present coupons are those with alternatives to pay interest periodically.
In other words, the investor does not need to wait for the product to mature to receive the money.
Now, if there is no coupon payment, the duration is equal to the maturity date. In fact, it is also known as maturity.
You need to keep in mind that if the interest rate rises, the tendency is for the duration to do the opposite, that is, fall.
This is because profitability increases. However, if interest rates fall, duration increases.
How to calculate duration with coupon?
First, identify how many semesters there are in three years. The next step is to calculate the coupon value.
Then you need to bring the coupon to the present value and perform the sum of all the coupons at the current value.
Who offers coupon bonds?
The private bond market offers coupon bond options. In addition, Tesouro Direto also offers fixed-rate bonds that pay periodic coupons.
In Tesouro Direto, we find the following alternatives that pay coupons:
- NTB-B (IPCA Treasury + With semi-annual interest)
- NTN-F (Treasury Prefix with semi-annual interest)
In the case of private securities, we find the offer of coupons in the following alternatives:
- CRI;
- CRA;
- Debentures.
Duration corresponds to the time remaining until maturity, in the case of fixed-rate securities that do not pay recurring coupons.
Small investors or beginner investors are not used to calculating duration, however, it is very important to understand the concept to diversify the risks of a fixed income securities portfolio.
What is Macaulay duration?
In 1938, Canadian economist Frederick Macaulay created the concept duration. It was created to balance investment portfolios.
As previously mentioned, the duration calculation considers some factors:
- Term of the title;
- Contracted income;
- Possibility of early redemption.
Since interest rates in the economy are dynamic, this concept is a great alternative to reevaluate investments periodically.
Therefore, duration is the calculation developed by the Canadian economist, which is why it has this name.
How to calculate Macaulay duration?
To calculate the formula of duration Macaulay It is necessary to add all future movements of the title, including coupons and principal amortization.
The sum should be multiplied by the relevant periods to maturity and discounted to its current value.
All of this divided by the current value of the asset.
How do investors use duration?
As you may have noticed, when the interest rate rises, the duration falls. In this case, as profitability increases, it will take less time for the bond to yield everything the investor is entitled to.
Ideally, the investor should use an investment with the longest duration, if he wants the interest to fall during the period in which he plans to hold the security.
In short, the value of the asset would increase more, compared to other investments with shorter duration.
It is worth noting that the shorter the duration of a security, the lower its volatility will be.
The use of duration should also be in line with your investor profile. For example, if you don't like taking risks or don't like large fluctuations, the ideal is to opt for a security with a short duration.
However, if you know how to deal with interest rates and feel more comfortable with fluctuations, that is, you like taking risks, you can invest in a bond with a longer duration.
The best way to reduce risks is to diversify your investment portfolio and monitor changes in interest rates.
This way, you will be able to act at the right time and reduce or avoid bigger problems.
Conclusion
Now you know what duration is in finance, how the calculation is performed and the importance of understanding the concept.
Before making a new investment, it is very important that you evaluate several factors, such as profitability, risk, minimum investment amount, liquidity, redemption period, among others.
This way, you can better analyze all these options and choose the investment that best suits your profile and financial goals.
